From farmers in the 1800s trading wheat with merchants, to modern day companies hedging against currency volatility, hedging has evolved quite a bit over the years. Here’s how FX hedging became a major influential force in the business and finance worlds.
How it all started
The earliest recorded accounts of hedging in business begin in the 1800s, involving farmers and the merchants who purchased their grain. Farmers wanted to make smarter predictions about how much grain to produce, and how much money they could expect to make from buying and selling it. Essentially, farmers would ask merchants to commit to buying grain at a future agreed-upon price, which would then be paid when the grain was delivered.
The significance of these agreements can’t be overstated - they allowed farmers to move forward with the assurance that they could expect a return on their agricultural “investment,” empowering them with the ability to effectively plan for the future. This pursuit of certainty and a desire to plan for the future with less risk is still the main driving force for companies using currency hedging today.
Where did the need for hedging come from?
Farmers in the 1800s wanted the same things that modern day businesses are chasing after: certainty and predictability. These agricultural businesses wanted to know the exact prices for the grain that they would sell in the future, so that they could calculate the potential revenue they would make. That information would help them understand how much they needed to produce in order to plan accordingly.
Farmers needed a clear understanding of supply and demand, as well as a way to reduce potential waste. This was paramount for farmers debating how much time and resources were required, so that they could achieve a specific financial result.
In fact, the farmers’ efforts to organize, negotiate, and lock in future grain prices with merchants led to the establishment of the Chicago Board of Trade (CBOT) in 1848. This was the first grain futures exchange in the United States. The invention of hedging in the US can be directly traced back to the CBOT and grain exchange.
Evolution: How hedging has changed
Hedging has come a long way since its early days, and is now a globally recognized necessity in business. Enterprises ranging from small businesses to global corporations have embraced hedging, providing stability and certainty in an unpredictable market. Studies have found that corporate FX hedging increases a company’s market valuation by an average of 4.87 percent.
Today, there are countless types of hedging, which go beyond currency. For example, some agricultural companies hedge raw materials, such as coffee, sugar, and rice. An airline company may hedge fuel, such as oil, while businesses in other industries may hedge physical commodities like metal and gold.
Hedging provides businesses with a buffer against market volatility, and helps bolster a company’s resilience against global economic forces which are out of an individual organization’s control.
A good example of this is happening currently in oil prices. As we all know, oil prices are spiraling upwards, driven by a combination of factors. Airlines for example are at risk here of not knowing how much they will pay per barrel in the future due to these changes. To provide stability, they can hedge against the costs by locking in future oil purchases using today's exchange rate. In this case, regardless of whether the price of oil continues to rise, or in fact drops, is now rendered insignificant as the business is certain of future expenses, allowing them to plan with greater certainty.
FX hedging in business
Corporate currency hedging entered a new era following the end of World War II, which saw the establishment of a policy that defined financial markets for decades. The Bretton Woods Agreement, which pegged currencies to gold at a stable rate of exchange, was established in 1944, and provided countries with a degree of certainty when it came to FX matters.
Although the Bretton Woods Agreement was officially defunct by the 1970s, the agreement prepared the ground for exploration that resonated with businesses that operate globally. Essentially, it gave them the ability to use multiple currencies for buying and selling. Currency hedging, which sees businesses and traders lock in exchange rates, emerged after Bretton Woods failed and FX rates became a ‘free-for-all’, vulnerable to dramatic fluctuations on a day-to-day basis.
Currency pairs are notoriously unstable and often surge or plunge multiple percentage points in the space of a short time. For example, the AUD (Australian Dollar) and JPY (Japanese Yen) pairing has historically seen dramatic ups-and-downs, especially in the last two years. At one point in 2020, the AUD traded 1 to 65 JPY, and as of September 2020 reached 1 to 95, a positive change of 46%.
Today, the FX market is the most liquid market in the world and is still subject to significant fluctuations. Major players in the FX market include governments, central banks, commercial banks, institutional investors, financial institutions and businesses, both corporations and SMEs.
Currency hedging today and a vision for the future
Currency hedging has evolved from large scale, mass hedges of balance sheet items that cover all of a company’s potential exposures to discrete hedging, which gives businesses the ability to be hyper precise in terms of which items to hedge and for how long. Discrete hedging provides complete flexibility, which is critical for SMEs that may need to hedge individual invoices or expenditures and can’t risk being locked into a long-term, wide-scale hedge.
The evolution of hedging to a practice that’s more accessible has greatly benefited SMEs, who can now leverage hedging. Previously, hedging was excessively expensive, creating a high degree of operational friction and requiring high collateral, which put the solution solidly out of reach of smaller enterprises.
In the coming years, we can expect to see the continued democratization of hedging services. As FinTech and embedded finance brings financial services and tools to the general public and removes previous barriers to entry which required clients to use formal, traditional banks, FX hedging is poised to follow suit and push that trend even further.
How FX hedging benefits your business
Currency hedging provides a number of valuable benefits to your organization. In an increasingly volatile, unpredictable market, hedging helps you protect your bottom line by reducing the risk of major losses stemming from currency fluctuations.
Hedging also provides much-needed stability and peace of mind for your business, as you can more accurately predict your future revenue and expenditures. Planning for the future and making decisions with absolute certainty is easier than ever, with FX hedging as a tool in your financial planning arsenal.
How do I start FX hedging?
Grain’s simple, automated hedging tool allows our partners and their customers to lock their rates and move funds across borders without hassle. Specifically, we provide businesses with an easy-to-use currency hedging tool, which can be easily embedded into any software platform or marketplace. This will not only increase your business retention by enhancing your offering and competitive standing with greater functionality, it will also help you win new business and boost revenue.
To learn more about how Grain can help you start offering FX hedging to your customers, get in touch with us. We’d love to tell you more about how we can help.